Economic value added
Encyclopedia
In corporate finance
, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co
., is an estimate of a firm's economic profit – being the value created in excess of the required return of the company's investors (being shareholder
s and debt holders). Quite simply, EVA is the profit earned by the firm less the cost of financing the firm's capital
. The idea is that value is created when the return on the firm's economic capital employed is greater than the cost of that capital; see Corporate finance: working capital management. This amount can be determined by making adjustments to GAAP
accounting. There are potentially over 160 adjustments that could be made but in practice only five or seven key ones are made, depending on the company and the industry it competes in.
) less a capital charge, the latter being the product of the cost of capital and the economic capital. The basic formula is:
where:
EVA Calculation:
EVA = net operating profit after taxes – a capital charge [the residual income method]
therefore EVA = NOPAT – (c × capital), or alternatively
EVA = (r x capital) – (c × capital) so that
EVA = (r-c) × capital [the spread method, or excess return method]
where:
r = rate of return, and
c = cost of capital, or the Weighted Average Cost of Capital
(WACC).
NOPAT is profits derived from a company’s operations after cash taxes but before financing costs and non-cash bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm.
Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less non-interest-bearing current liabilities (NIBCLs).
The capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of economic capital invested.
The cost of capital is the minimum rate of return on capital required to compensate investors (debt and equity) for bearing risk, their opportunity cost.
Another perspective on EVA can be gained by looking at a firm’s return on net assets (RONA). RONA is a ratio that is calculated by dividing a firm’s NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system.
EVA = (RONA – required minimum return) × net investments
If RONA is above the threshold rate, EVA is positive.
Although in concept, these approaches are in a sense nothing more than the traditional, commonsense idea of "profit", the utility of having a separate and more precisely defined term such as EVA is that it makes a clear separation from dubious accounting adjustments that have enabled businesses such as Enron
to report profits while actually approaching insolvency.
Other measures of shareholder value
include:
, or MVA, is the discounted sum (present value) of all future expected economic value added:
Note that MVA = PV of EVA.
More enlightening is that since MVA = NPV of Free cash flow
(FCF) it follows therefore that the
NPV of FCF = PV of EVA;
since after all, EVA is simply the re-arrangement of the FCF formula.
Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co
Stern Stewart & Co
Stern Stewart & Co is a worldwide management consulting firm founded in New York in 1982. The company developed the Economic value added concept and currently owns the trademark. The current CEO and chairman of Stern Stewart & Co., New York is Joel M. Stern...
., is an estimate of a firm's economic profit – being the value created in excess of the required return of the company's investors (being shareholder
Shareholder
A shareholder or stockholder is an individual or institution that legally owns one or more shares of stock in a public or private corporation. Shareholders own the stock, but not the corporation itself ....
s and debt holders). Quite simply, EVA is the profit earned by the firm less the cost of financing the firm's capital
Cost of capital
The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
. The idea is that value is created when the return on the firm's economic capital employed is greater than the cost of that capital; see Corporate finance: working capital management. This amount can be determined by making adjustments to GAAP
Gaap
In demonology, Gaap is a mighty Prince and Great President of Hell, commanding sixty-six legions of demons. He is, according to The Lesser Key of Solomon, the king and prince of the southern region of Hell and Earth, and according to the Pseudomonarchia Daemonum the king of the western region and...
accounting. There are potentially over 160 adjustments that could be made but in practice only five or seven key ones are made, depending on the company and the industry it competes in.
Calculating EVA
EVA is net operating profit after taxes (or NOPATNOPAT
In corporate finance, net operating profit after tax or NOPAT is a company's after-tax operating profit for all investors, including shareholders and debt holders. It is equal to NOPLAT and is defined as follows:An alternative formula is as follows...
) less a capital charge, the latter being the product of the cost of capital and the economic capital. The basic formula is:
where:
, is the Return on Invested Capital (ROIC);
is the weighted average cost of capitalWeighted average cost of capitalThe weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....
(WACC);
is the economic capital employed;- NOPATNOPATIn corporate finance, net operating profit after tax or NOPAT is a company's after-tax operating profit for all investors, including shareholders and debt holders. It is equal to NOPLAT and is defined as follows:An alternative formula is as follows...
is the net operating profit after tax, with adjustments and translations, generally for the amortization of goodwill, the capitalization of brand advertising and others non-cash items.
EVA Calculation:
EVA = net operating profit after taxes – a capital charge [the residual income method]
therefore EVA = NOPAT – (c × capital), or alternatively
EVA = (r x capital) – (c × capital) so that
EVA = (r-c) × capital [the spread method, or excess return method]
where:
r = rate of return, and
c = cost of capital, or the Weighted Average Cost of Capital
Weighted average cost of capital
The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....
(WACC).
NOPAT is profits derived from a company’s operations after cash taxes but before financing costs and non-cash bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm.
Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less non-interest-bearing current liabilities (NIBCLs).
The capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of economic capital invested.
The cost of capital is the minimum rate of return on capital required to compensate investors (debt and equity) for bearing risk, their opportunity cost.
Another perspective on EVA can be gained by looking at a firm’s return on net assets (RONA). RONA is a ratio that is calculated by dividing a firm’s NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system.
EVA = (RONA – required minimum return) × net investments
If RONA is above the threshold rate, EVA is positive.
Comparison with other approaches
Other approaches along similar lines include residual income (RI) and residual cash flow. Although EVA is similar to residual income, under some definitions there may be minor technical differences between EVA and RI (for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Residual cash flow is another, much older term for economic profit. In all three cases, money cost of capital refers to the amount of money rather than the proportional cost (% cost of capital); at the same time, the adjustments to NOPAT are unique to EVA.Although in concept, these approaches are in a sense nothing more than the traditional, commonsense idea of "profit", the utility of having a separate and more precisely defined term such as EVA is that it makes a clear separation from dubious accounting adjustments that have enabled businesses such as Enron
Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
to report profits while actually approaching insolvency.
Other measures of shareholder value
Shareholder value
Shareholder value is a business term, sometimes phrased as shareholder value maximization or as the shareholder value model, which implies that the ultimate measure of a company's success is the extent to which it enriches shareholders...
include:
- Added valueAdded valueAdded value in financial analysis of shares is to be distinguished from value added. Used as a measure of shareholder value, calculated using the formula:...
- Market value addedMarket value addedMarket Value Added is the difference between the current market value of a firm and the capital contributed by investors. If MVA is positive, the firm has added value. If it is negative, the firm has destroyed value...
- Total shareholder returnTotal Shareholder ReturnTotal Shareholder Return is a concept used to compare the performance of different companies’ stocks and shares over time. It combines share price appreciation and dividends paid to show the total return to the shareholder...
.
Relationship to market value added
The firm's market value addedMarket value added
Market Value Added is the difference between the current market value of a firm and the capital contributed by investors. If MVA is positive, the firm has added value. If it is negative, the firm has destroyed value...
, or MVA, is the discounted sum (present value) of all future expected economic value added:
Note that MVA = PV of EVA.
More enlightening is that since MVA = NPV of Free cash flow
Free cash flow
In corporate finance, free cash flow is cash flow available for distribution among all the securities holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on....
(FCF) it follows therefore that the
NPV of FCF = PV of EVA;
since after all, EVA is simply the re-arrangement of the FCF formula.
See also
- Business valuationBusiness valuationBusiness valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business...
- Free cash flowFree cash flowIn corporate finance, free cash flow is cash flow available for distribution among all the securities holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on....
- Enterprise valueEnterprise valueEnterprise value , Total enterprise value , or Firm value is an economic measure reflecting the market value of a whole business. It is a sum of claims of all the security-holders: debtholders, preferred shareholders, minority shareholders, common equity holders, and others...
- Opportunity costOpportunity costOpportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen . It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the...
- Value addedValue addedIn economics, the difference between the sale price and the production cost of a product is the value added per unit. Summing value added per unit over all units sold is total value added. Total value added is equivalent to Revenue less Outside Purchases...
- Weighted average cost of capitalWeighted average cost of capitalThe weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....
External links
- http://www.stasegem.be/PRVit/PRVitList.php Free online PRVit analysis form shares on US Stockmarket
- What's wrong with the Economic Value Added?, Sergei Cheremushkin, 2008
- A Reading List on EVA/Value Based Management from Robert Korajczyk
- Economic Value Added from EVA Dimensions LLC
- Economic Value Added (EVA), Prof. Aswath DamodaranAswath DamodaranAswath Damodaran is a Professor of Finance at the Stern School of Business at New York University , where he teaches corporate finance and equity valuation...
- EVA valuation tutorial from valuatum.com
- Understanding Economic Value Added, investopedia.com
- All About EVA, investopedia.com
- Economic Value Added: A simulation analysis of the trendy, owner-oriented management tool, Timo Salmi and Ilkka Virtanen, 2001
- The Origins of EVA Chicago-Booth magazine